Marginal cost is the cost of one additional unit of output. The concept is used to determine the optimum production quantity for a company, where it costs the least amount to produce additional units. If a company operates within this "sweet spot," it can maximize its profits. The concept is also used to determine product pricing when customers request the lowest possible price for certain orders.
For example, a production line currently creates 10,000 widgets at a cost of $30,000, so that the average cost per unit is $3.00. However, if the production line creates 10,001 units, the total cost is $30,002, so that the marginal cost of the one additional unit is only $2. This is a common effect, because there is rarely any additional overhead cost associated with a single unit of output, resulting in a lower marginal cost.
In rare cases, step costs may take effect, so that the marginal cost is actually much higher than the average cost. To use the same example, what if the company must start up a new production line on a second shift in order to create unit number 10,001? If so, the marginal cost of this additional unit might be vastly higher than $2 - it may be thousands of dollars, because the company had to start up an extra production line in order to create that single unit.
A more common situation lying between the preceding two alternatives is when a production facility operating near capacity simply pays overtime to its employees for them to work somewhat longer to put out that one additional unit. If so, the marginal cost will increase to include the cost of overtime, but not to the extent caused by a step cost.
The marginal cost of customized goods tends to be quite high, whereas it is very low for highly standardized products that are manufactured in bulk. The reason for the difference is that the variable cost associated with a customized product tends to be higher than for a standardized product. A high level of standardization is usually achieved with more automation, so the variable cost per unit is low and the fixed cost of manufacturing equipment is high.
Since marginal cost is only used for management decision making, there is no accounting entry for it.
Marginal cost is the same as incremental cost.